1. Cost-Benefit Analysis
CHAPTER 8
Cost-Benefit Analysis
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Projecting Present Dollars into the Future
RT = R0*(1+r)T
one click per line

3. Projecting Future Dollars into the Present
RT = R0*(1+r)T
5 lines visible
1st click – 6th line
7th click – “Present Value”
8th click – “discount rate”
9th click ‘ discount rate arrow disappears, bracket appears, “discount factor”
Present Value
R0 = RT/(1+r)T
discount rate
discount factor

4. Present Value of a Stream of Money

5. Inflation

6. Private Sector Project Evaluation
Annual Net Return PV
Year
R&D
Advertising
R =
$1,000
-$1,000
$150
$200 1
600
0.01
128
165 2
0.03 86 98 3
550
1,200
0.05 46 37
0.07 10
-21
Admissible
Preferable
Present Value Criteria

7. Internal Rate of Return
Project
Year 0
Year 1 ρ
Profit PV X
-$100
$110
10% $4
3.77 Y
-$1,000
$1,080 8%
$20
18.87

8. Benefit-cost ratio = B/C

9. Problems with the Benefit-Cost Ratio
Method B C
B/C I
$250
$100
2.5 II
$200
2.0
I: Subtract $40 mistake from B
$210
2.1
I: Add $40 mistake to C
$140
1.79

10. Discount Rate for Government Projects
Returns in Private Sector
Social Discount Rate
Paternalism
Market Inefficiency
Discounting and the Economics of Climate Change
Government Discounting in Practice

11. Valuing Public Benefits and Costs
Market Prices
Adjusted Market Prices
Shadow price
Monopoly
Taxes
Unemployment
Consumer Surplus e
Price per pound of avocados b d Sa
$2.89 c g
Sa’
1st click – left-hand side text line-by-line
2nd click - axes and labels, D, S, A, d, and g
3rd click – S’, A1
$1.35 Da
Pounds of
avocados per year A0 A1

12. Inferences from Economic Behavior
The Value of Time
The Value of Life
Lost earnings
Probability of death

13. Valuing Intangibles Subverting cost-benefit exercises
Reveal limits on intangibles
Cost-effectiveness analysis

14. Games Cost-Benefit Analysts Play
The Chain-Reaction Game
The Labor Game
The Double-Counting Game

15. Distributional Considerations
Hicks-Kaldor Criterion – a project should be undertaken if it has positive net present value, regardless of distributional consequences
Government costlessly corrects any undesirable distributional aspects
Weighted benefits

16. Uncertainty Certainty Equivalent Project Benefit Probability EV X
$1,000
1.00 Y
0.50
$2,000
Certainty Equivalent

17. Are Reductions in Class Size Worth It?
Discount rate
Costs
Benefits
The Bottom Line and Evaluation

18. Use (and Nonuse) by Government
Using Cost-Benefit Analysis
Not Using Cost-Benefit Analysis
Clean Air Act
Endangered Species Act
Food, Drug, and Cosmetic Act

19. Calculating the Certainty Equivalent Value
Utility
U(E + y) U*
U(E)
Certainty Equivalent
Expected income E C I*
E + y
Income per year